The present invention relates to administering, e.g., for asset/liability management and/or tax purposes, the hedging of certain obligations of an employer or plan sponsor in an employee deferred compensation plan using total return swaps and/or options and/or forwards. In the United States, the invention relates to administering the hedging of such obligations in a nonqualified (under the United States Internal Revenue Code) deferred employee compensation (or NQDC) plan.
The invention has particular application to NQDC plans in the United States. Therefore, the description below is directed to application of the invention to NQDC plans with the understanding that the invention may have application to other plans both in the United States and in other jurisdictions which may or may not involve tax consequences triggered by a withdrawal by, or a distribution or award to, a plan participant under the plan. Implementation of the invention in such other applications will be evident to persons of skill in the relevant art(s) in the United States and in other countries.
NQDC plans have become increasingly popular since they allow employers to provide tax-deferred compensation to select employees. In fact, an estimated 85% of the Fortune 1000 companies use such plans to compensate their executives. Smaller companies as well have realized the benefit of such plans. Under a NQDC plan, the income tax on the compensation is not immediately realized by the employee when it is awarded, and such compensation is not taxed to the employee until it is actually withdrawn, which may be several years after it is awarded. Although the compensation is not tax deductible to the employer until it is received by the employee, the employer avoids the need to immediately allocate funds to compensate the employee, and the employee gains no property right in the deferred compensation on any earnings related to the deferred compensation until they are received by the employee.
An NQDC plan must not be formally funded to avoid a constructive receipt of the compensation by the employee, and NQDC plan obligations appear as expenses on the employer's income statement, creating an open liability on its balance sheet until the benefits are paid. The eventual withdrawal of the benefits results in a cash outflow from the employer. As these cash outflows can prove untimely if left unhedged, the employer may choose to hedge its NQDC plan obligation, typically by purchasing taxable investments or corporate-owned life insurance. The adequacy of such hedges vary in regard to their relative tax ramifications and or economic ramifications as compared to the obligation(s).
Total return swaps, options, and forwards have been used by companies to hedge their balance sheet. However, the use of swaps, options, and forwards to hedge NQDC plan employer obligations in particular has been limited. Formerly, they would have been an alternative to taxable investments and did not provide any significant benefit to the employer over any other taxable investments. Recently, however, the use of taxable investments as a hedge for tax purposes has been eliminated under the Internal Revenue Code (IRC). Treasury regulation section 1.1221-2(d)(5) states that, unless published guidance or a private letter ruling from the Internal Revenue Service determines otherwise:                [T]he purchase or sale of a debt instrument, an equity security, or an annuity contract is not a hedging transaction even if the transaction limits or reduces the taxpayer's risk with respect to ordinary property, belongings, or ordinary obligations.        
This regulation leaves swaps, options, and forwards as attractive alternatives for tax-conscientious companies with outstanding NQDC plan liabilities to hedge.
Published Patent Application No. US 2002/0174044 A1 discloses a concept for hedging the liabilities of a deferred compensation plan using total return swaps and/or options and/or forwards. As disclosed in that application, a plan sponsor, e.g., an employer, enters into an agreement with a swap counterparty under which the plan sponsor hedges its liability under an NQDC plan in return for payments to the swap counterparty. For options and forwards, the agreement would be between the plan sponsor and an option dealer and a forward dealer, respectively. The swap counterparty, the option dealer and the forward dealer are generically and collectively referred to herein as a “balance sheet provider,” which is typically an independent third party. Employees who are selected and participate in the plan are referred to herein as plan participants. The concept described in this published patent application involves retention by a plan sponsor typically of a plan administrator, such as a financial services organization, to handle the administration of the plan, or the plan administrator may be part of the plan sponsor.
In the agreement between the balance sheet provider and the plan sponsor mentioned above, referred to herein as a “hedge agreement” or “hedge instrument,” the balance sheet provider agrees to pay the plan sponsor an amount based on a notional investment realized via swaps and/or options and/or forwards, in one or more hedging benchmarks, such as a money market fund, a fixed income fund, an equity fund, a balanced fund, an S&P 500 stock fund, and so forth. In return, the plan sponsor pays the balance sheet provider a fee, which may be based on an interest rate benchmark plus a spread. The plan sponsor uses the proceeds from the swap and/or options and/or forwards to hedge its obligation to the plan participants and to partially fund the obligation when participants withdraw amounts from their plans.
The plan sponsor can potentially benefit from the concept described above in the following ways:                (a) Balance Sheet Usage: The plan sponsor frees up funds it would have otherwise used to buy a cash asset (e.g., taxable investments or corporate owned life insurance) and may make these funds available to reinvest in its business.        (b) Taxes: The plan sponsor benefits from the swap and/or options and/or forwards hedging structure because the swap gains are not taxed until the sponsor pays a participant's withdrawal request from the plan. Fees paid to the balance sheet provider by the plan sponsor are tax-deductible, generally at the time of the withdrawal payment.        (c) Liquidity Match: The plan sponsor receives payments from the balance sheet provider at the time when the sponsor is obligated to pay plan participants payments for withdrawals or earlier, thereby providing a liquidity match between the plan sponsor's liability cash flow out with a cash flow in from the hedge.        (d) Lower Cost: The plan sponsor pays the balance sheet provider a fee based on an interest rate benchmark and a spread. The fee is only a small percentage of the total liability being hedged for the plan sponsor and generally is less than the cost of Corporate Owned Life Insurance (COLI), currently a popular hedge instrument for NQDC plans.        (e) Minimal Tracking Error: The hedge provided by the balance sheet provider may be based on the same notional investments used in the plan. That is, when the plan sponsor owes an amount based on a notional investment in fund A, the hedge can be designed so that the balance sheet provider owes an amount to the plan sponsor based upon a notional investment in the same fund, matching the plan sponsor's plan obligation perfectly with the hedge.        